Wherefore the corporate tax?

The only thing exciting about the discussion on corporate taxes last week was a proposal by the command-economy President to reduce the top rate to 28% from 35%.  The non-existence of a forceful Republican response, from Congress or the Presidential candidates, adumbrates the continuing weakness in their philosophical understanding.

Sen. Orrin Hatch said the President should provide leadership on this issue, exposing his and the GOP’s own lack of it.  The leader-aspirants were equal supine.  The “business-experienced” candidate, Romney, offered a 25% tax rate, glibly confident that the 3% differential with Obama would excite voters and markets.  The others had previously proffered proposals that seem to have been lifted from a bingo game: Gingrich 12% (with no capital gains and dividends tax), Paul 15%, Santorum, 17.5% (zero for manufacturers).  None of these has any basis in economics and are all therefore indefensible, with the exception of Gingrich's plan that effectively removes double taxation and reduces the tax on profits to the lowest individual rate.

The only answer that makes sense, and the one answer that would have put the GOP on an incommutable foundation: the corporate tax is a double tax and should be abolished.

It is not surprising that the left has marketed the notion that the corporate tax is a levy on all businesses, and necessary to control self-enriching executives who exploit workers and the environment.  It is surprising the right has allowed them to get away with it.

The corporate tax, introduced in 1909, is not paid by every business and not just by large corporations.  The IRS reports1 six million active corporations in 2008 (the most recent report).  Of these, 4.1 million—68%—are pass-through entities, mostly businesses with fewer than 100 shareholders (“S-corporations”).  These businesses pay no tax, because their income is allocated to their shareholders who pay tax at their individual rates on their portion of the business’ profit.

The “corporate tax”, then, refers to the 32% or two million remaining businesses classified as C-corporations, entities with over 100 shareholders.  Small companies, with assets under $2.5 million and net income under $2 million, comprise 93% of these C-Corps.

C-corps pay from 15% to 35% Federal tax on their income2, which top rate is the highest in the OECD3.  All but three states impose an additional corporate income tax.  With Federal and state rates combined, government takes as much as 40% from profitable activities before a single dollar reaches the pockets of shareholders.

Thus, a dollar earned by a corporation is reduced to 60 cents after Federal and State income taxes.  Those 60 cents are taxed again when paid to the shareholder investors in the form of dividends or capital gains, leaving a return on their investment and reward for their risk of only 51 cents.  This amounts to an aggregate tax of 49%.4

If the 2005 dividend and capital gain tax cuts are not made permanent, that dollar of business profit becomes as low as 36 cents if paid as dividends—because dividends will be treated as ordinary income after 2012, and 48 cents if paid as capital gains.5  These are confiscatory taxes that would throttle capital formation, the lifeline of entrepreneurship and economic expansion.  If this differential between dividends and capital gains is not corrected, shareholders will be less inclined to invest in dividend paying companies. 

The total net Federal corporate income tax collected from C-corps was $228 billion, or just 15% of the $1.4 trillion in tax receipts (excluding employment tax that is theoretically applied to social security).  Less than 3,000 C-corps—0.04% of the total—report assets over $2.5 billion, but these pay almost 70% of all corporate income taxes. 

One observation from these data is that the corporate income is highly progressive, skewing burden to large corporations.  But large corporations have learned to play the game to their advantage, tolerating the nominal corporate tax in exchange for their opportunity to gain tax advantage over competitors.  The halls of big accounting firms are filled with well compensated specialists whose sole job for clients is tax avoidance and tax arbitrage—shifting tax recognition from high tax countries to low. 

These unproductive activities traduce capitalism and foster corporatism. The scope is disquieting.  Total corporate income tax before credits was $342 billion on about $977 billion in income (exactly 35%).  But the net tax of $228 billion mentioned above, resulted from credits of $114 billion that reduced the tax.  Thus, the average tax rate drops to 23% ($228/977) because of these machinations, and in General Electric’s case last year to 0%.

The Cato Institute6 has published extensive studies on “corporate welfare”, defined as “any federal spending program that provides payments or unique benefits and advantages to specific companies or industries”.  The groveling for these taxpayer funded handouts keeps lobbyists in Brooks Brothers suits as it distorts market decisions and enflames the perception of crony capitalism.

What is the effect of the corporate tax on the economy?  A recent study7 by the Congressional Budget Office surveying scholarly papers from 1962 through 1992 examining “corporate tax incidence” concluded that the tax falls directly as a cost on capital rather than on labor.  But who owns this capital? 

Seventy percent of households and non-profits8 hold $26 trillion in corporate equities, and in mutual funds, pensions, and retirement accounts—which invest in equities and corporate bonds.  Therefore, any cost on capital is a cost on the savings and investments of all Americans.

Had the reverse been true—had the cost fallen on labor—we would have been subject to expostulations from the left whose silence now, with limited exception, ignores the principle that capital is requisite for labor’s employment.  This exception includes Robert Reich9 and Lester Thurow, whose understanding of ill effects of double taxation invites bipartisan action—if only the right were as clear headed as Milton Friedman who first proposed abolishing the double tax in 1962, and more recently, Michael Boskin10.

Reich waxes lucidly, “An idea advanced by Professor Lester Thurow of MIT is to get rid of the corporate income tax and have shareholders pay personal taxes on all income earned by the corporation on their behalf—whether the income is retained by the corporation or is paid out as dividend.  This would essentially reveal what the corporation is in fact—a partnership of shareholders. All corporate earnings would be treated as personal income.”

Government revenues under this plan would be unchanged: a 23% personal tax on $1 trillion in aggregate net corporate income is still $230 billion in corporate taxes.

So, what is the point of abolishing the double tax?  The National Bureau of Economic Research11 concluded in 1985 that such “tax integration” resulting in the end of double taxation would yield dynamic economic efficiencies of $1.5 to $3.4 trillion in today’s dollar, mostly because of an influx of capital investment and economic activity.  Therefore, it costs the country nothing to gain recurring benefit in the trillions.  The market unleashed provides stimulus.

As we have written elsewhere12, economists and the Treasury Department have studied various mechanisms for tax integration since 1977.  The resistance to it appears not to issue solely from politicians with feeble knowledge of economics or lack of courage, but from corporate executives. 

A study of the history of double taxation by law professor Steven Bank13 concludes, “The distinction between double taxation's rise and its persistence is the role of managers.  As the history surrounding the rise of double taxation demonstrates, corporate managers actively supported double taxation only in the context of a direct challenge to their ability to retain earnings.  While some may oppose integration today, most managers publicly support it even while actively pursuing other goals.  The implication is that corporate managers are likely to actively lobby for integration only when repealing double taxation is a potential solution to a direct challenge to their interests.  Just as corporate managers played a significant role in the rise of double taxation, so too must they play a role in its fall for integration efforts to succeed.” 

---

[1] Internal Revenue Service. 2008 Corporation Income Tax Returns. http://www.irs.gov/pub/irs-soi/08coccr.pdf

[2] Tax Foundation. Federal Corporate Income Tax Rates. http://www.taxfoundation.org/taxdata/show/2140.html

[3] Tax Foundation. National and State Corporate Income Tax Rates, U.S. States and OECD Countries, 2011.  http://www.taxfoundation.org/taxdata/show/23034.html 

[4] Assuming all taxes are paid at the highest marginal rate, the combination of Federal and State tax rates is 40% in most States.  The current dividend and capital gains tax is 15%. Therefore, after all taxes are paid, the shareholder receives $1 x (1-0.40) x (1-0.15) = $0.51.

[5] Again using the top rates, dividends will be treated as ordinary income after 2012, with a top rate of 39.6%.  The capital gains rate will rise to 20%.  Therefore for dividends, $1 of corporate profit will yield for the shareholder: $1 x (1-0.40) x (1-0.396) = $0.36

For capital gains: $1 x (1-0.40) x (1-0.20) = $0.48

These calculations do not include the new Obamacare Medicare tax on investment income of 3.8%.

[6] Cato Institute: The Corporate Welfare State: How the Federal Government Subsidizes U.S. Businesses. http://www.cato.org/publications/policy-analysis/corporate-welfare-state-how-federal-government-subsidizes-us-businesses

[7] Congressional Budget Office: Working Paper 2010-03: Corporate Tax Incidence: Review Of General Equilibrium Estimates And Analysis. http://www.cbo.gov/publication/21486

[8] U.S. Census Bureau. Flow of Funds Accounts—Assets of Households and Nonprofit Organizations: 1990 to 2010. http://www.census.gov/compendia/statab/2012/tables/12s1170.pdf

[9] Reich, Robert. Supercapitalism. New York: Vintage Books, 2008

[10] Boskin, Michael. Time to Junk the Corporate Tax. http://www.stanford.edu/~boskin/Publications/wsj%20op-ed%2005%2006%202010.pdf

[11] National Bureau of Economic Research. “Integration of the Corporate and Personal Income Taxes.” in A General Equilibrium Model for Tax Policy Evaluation, Chicago: University of Chicago Press, 1985  http://www.nber.org/chapters/c11220.pdf

[12] Avari. The perils of double taxation.  American Civility and Human Events. http://americancivility.us/american-civility/2010/4/19/the-perils-of-double-taxation.html

and in Human Events: http://www.humanevents.com/article.php?id=36568

[13] William and Mary Law Review. Corporate Managers, Agency Costs, And The Rise Of Double Taxation. http://scholarship.law.wm.edu/cgi/viewcontent.cgi?article=1393&context=wmlr&sei-redir=1&referer=http%3A%2F%2Fwww.google.com%2Furl%3Fsa%3Dt%26rct%3Dj%26q%3Dcorporate%2520managers%252C%2520agency%2520costs%252C%2520and%2520the%2520rise%2520of%2520double%2520taxation%26source%3Dweb%26cd%3D2%26ved%3D0CCgQFjAB%26url%3Dhttp%253A%252F%252Fscholarship.law.wm.edu%252Fcgi%252Fviewcontent.cgi%253Farticle%253D1393%2526context%253Dwmlr%26ei%3DJ1ZWT5-YKMni0QHA7-mrCg%26usg%3DAFQjCNG9IHjSrAP-8m3qseTBtc8Bnlh__w#search=%22corporate%20managers%2C%20agency%20costs%2C%20rise%20double%20taxation%22